Pension funds are traditionally conservative investors but the sub-inflation returns of government bonds are encouraging change.
In theory, a 15-year gilt with returns that match expectations of liabilities is an ideal investment. However, heavy demand for haven assets and a fair amount of quantitative easing by governments has pushed real yields into negative territory for the first time in living memory.
As a result, only the most desperate pension funds are currently adopting such a strategy.
Alasdair MacDonald, head of investment strategy at Towers Watson, which advises many of the UK’s largest private sector schemes, says: “The high potential cost of derisking at the current time must be set against the risk of further short term deterioration. For very risk averse funds such as those with a weak sponsor and poor solvency level it may still be attractive. However, for many this is no longer the case and so the pace of derisking has slowed.”
For those that can afford to wait, he is seeing some sell high performing equities and purchase non-matching bonds such as short-dated index-linked gilts. This protects against spikes in inflation, but retains the option to reinvest at higher potential yields when the bonds mature.
Another wait and see approach is the trigger-based buying of gilts. Here, purchases are triggered whenever a scheme’s funding reaches an acceptable level or when yields hit acceptable levels.
John Dewey, managing director in BlackRock’s multi-asset team, says that, if yields remain low, schemes will take some pain by reanchoring their yield triggers closer to current levels. However, trigger frameworks have helped some of his clients to profit from market opportunities this year.
“Plans have grasped the opportunities to add value as a result of movements in inflation break-evens and differentials between inflation markets so far in 2012,” he says.
In common with many fund managers Mr Dewey advises the use of derivatives wherever a scheme cannot afford to sell growth assets. Here he favours gilt total-return swaps or repurchase agreements on gilts (repos).
The use of derivatives is an area many trustees have shied away from, but there is no shortage of advisers advocating change.
Pfaroe, asset liability modelling software which is accessed online, has recently been offered free to all clients of the mid-tier consultancy Punter Southall – a first for the industry.
The software illustrates to schemes how conventional assets rarely offer smooth expected returns that match promises to pay pensions. It also offers interest rate and inflation swap modelling that shows how derivatives can fill this gap.
John Belgrove, senior investment manager for AonHewitt, agrees. “Synthetic bonds structured correctly allow investors (or fund managers) to be more precise, more flexible, more capital efficient and to profit from occasional market anomalies,” he says.
One derivatives-based approach is described by Craig Inches, a government bond manager at RLAM. In this higher risk strategy a scheme will buy corporate bonds instead and put an inflation swap on top.
“You are basically buying into a real yield of 1.5-2 per cent, which is something schemes find more palatable than locking into real yields of zero at the long end.”
“The problem is it brings in another risk factor which is credit risk as opposed to inflation risk. You take your choice, if you are comfortable with that risk you take that instead of inflation hedging.”
Another approach has been the creation of patchwork or synthetic gilts, where the duration curve of a 15-year gilt with an attractive yield is recreated from many parts.
In the specialised, liability driven pooled funds offered by F&C Investments to help keep the cost of such strategies down for small to medium sized schemes, a combination of gilts, interest rate swaps, inflation swaps, gilt futures and repos are used.
Julian Lyne, managing director of institutional at F&C, explains: “You can make an incremental return by being in the most efficient instrument for hedging across the curve. It is still a hedge, but using the highest yielding instrument at each maturity.”
Ironically, the evolution of such strategies has come about not just because gilt yields have slipped, but also, says Mr Lyne, as a recognition that swaps no longer reliably yield more than gilts the way they did before 2008.
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